Public Information Notice No. 01/122

Public Information Notice: IMF Concludes 2001 Article IV Consultation with Finland

November 21, 2001

On November 9, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Finland.¹

Background

Sound macroeconomic policies and growing economic openness were at the root of Finland's remarkable recovery from the recession of the early 1990s. During 1994-2000, real GDP growth averaged almost 5 percent, with an exceptionally favorable international environment boosting growth in 2000 to 5¾ percent. Annual inflation during the whole period was in the range of 1 to 3 percent. Meanwhile, the economy became increasingly open, driven by a dynamic information and communications technology (ICT) sector. These structural changes brought large benefits to the economy, but also raised its exposure to a slowdown in international demand and weaker prospects for the ICT sector.

In light of the substantially weakened external environment, a marked slowdown of growth is expected this year and next from last year's rapid pace. Economic indicators clearly deteriorated in the course of 2001. Export growth dropped markedly, and GDP growth is forecast to slow to just below 1 percent this year. On the premise of a relatively short-lived fallout from the September 11 events, foreign demand is assumed to start recovering in the first half of 2002, with economic growth projected to pick up mildly to 2 percent in 2002. Absent a significant increase in energy prices, CPI inflation (harmonized) is projected to fall to an average of 2½ percent in 2001, with slower wage growth in a weakened economic environment contributing to a further deceleration below 2 percent in 2002. Macroeconomic policies are currently supportive of economic activity. Monetary conditions have been accommodative for some time, which reflects a competitive exchange rate and European Central Bank interest rate cuts since May 2001. The fiscal stance, on the other hand, turned moderately stimulative only this year, after a sizeable withdrawal of demand in 2000.

Finland's main structural problems are high unemployment and the foreseeable consequences of rapid population aging. After the large labor-shedding of the recession years, employment has been growing steadily, but the unemployment rate remains close to 10 percent. At the same time, labor supply is depressed by a low effective retirement age, and rapid population aging will place growing strains on labor markets, economic growth, and the public finances.

Executive Board Assessment

Executive Directors commended the Finnish authorities for their sound macroeconomic policies, that have turned the sizable fiscal deficits of the mid-1990s into solid surpluses and fostered rapid economic growth with low inflation and a strong external position. Directors stressed the benefits of the export-driven transformation of Finland's economy, but noted the economy's increased vulnerability to external shocks, which has led to a marked deceleration of economic growth in the midst of the current global slowdown. They nevertheless considered that the economy remains fundamentally sound and therefore expected economic growth to accelerate again as international demand recovers. Directors encouraged the authorities to step up the pace of reforms to ensure that the benefits of productivity growth of the ICT sector are distributed across the economy.

Directors emphasized that policy responses to the short-term outlook need to be framed in the context of long-term challenges. In view of rapid population aging, they strongly supported the government's goal of a significant and durable increase in the employment rate. Without such an increase, economic growth would be curtailed sharply in the face of a shrinking labor force, and there would be too few workers to support a growing number of pensioners. Against this background, Directors commended the authorities' proactive approach to addressing these problems and urged them to implement a comprehensive set of reforms to stimulate employment creation, including further reductions in the heavy tax burden on labor and reforms of the benefits, wage, and pension systems.

In light of the sharp deceleration of growth and slowing inflation, Directors viewed the current worsening of the cyclical outlook as an excellent opportunity for a tax-based fiscal easing. In this context, they welcomed the government's decision to augment planned labor tax cuts in 2002. Indeed, to support economic activity in both the short and long term, Directors advocated somewhat larger reductions in taxes on labor over the 2002-2004 period than currently planned. At the same time, Directors supported the government's policy of not offsetting cyclical declines in revenues, noting that the associated fall in the fiscal surplus should not be a cause for concern.

To leave room for needed tax cuts on labor, while maintaining sufficiently large structural fiscal surpluses in preparation for the demographic shock, Directors emphasized the need for ongoing expenditure restraint. Fiscal surpluses, by allowing the government to reduce debt and generate interest savings over time, would help safeguard priority spending without burdening future generations with excessive taxes. Directors considered a freeze in real central government spending, along the lines of the government's current medium-term plan, as appropriate to provide room for durable tax cuts while maintaining adequate surpluses.

Directors observed that the pension reform, aimed at appropriately rewarding a longer working life, would substantially ease the consequences of Finland's looming demographic shock. They welcomed the authorities' plans to enact further reforms of the pension system, with a view to tightening the link between lifetime contributions and benefits and thereby strengthening the incentives to work longer, and encouraged them to do so soon. In the same vein, Directors urged a swift discontinuation of various subsidized early-retirement schemes.

Directors emphasized the benefits of labor market reforms to strengthen employment and growth and thereby also the public finances. They recommended a comprehensive approach, complementing labor tax cuts with reforms to the benefits system, to address work disincentives and encourage swift job search, and to the wage bargaining system to allow wages to be more responsive to differences in productivity developments and labor demand. Directors viewed these measures, taken in combination and coupled with effective job training and counseling, particularly for young and unskilled workers, as the most promising way to encourage and enable more people to play an active role in the productive work force. Directors generally supported across-the-board tax cuts, but some Directors suggested that greater emphasis be put on labor tax cuts for low-income workers, where unemployment is concentrated.

Directors noted the strong potential of Finland's underdeveloped private services sector for employment creation and growth. They highlighted the key role of reforms to tax, benefits, and wage systems in realizing this potential and encouraged opening up the publicly-dominated markets for health and social services to greater private competition. To foster the creation of small businesses providing personal services, Directors also saw merit in making existing labor market regulations more easily accessible and understandable, and in reductions of indirect taxes, subject to ongoing spending discipline in the public sector. They also urged the authorities to address incentive problems that hamper the provision of more affordable housing in high-growth areas where the demand for labor, including in the services sector, is highest.

Directors welcomed the Financial System Stability Assessment findings that Finland's financial sector is in a very sound state. They cautioned, however, that this should not delay reforms to strengthen effective supervision. In the country's rapidly evolving financial landscape, characterized by a few systematically important institutions with complex cross-border and cross-industry structures, supervisors would need to play a proactive role at an early stage to counter any potential emerging vulnerabilities. To this effect, Directors urged the swift enactment of improved supervisory and regulatory legislation, and encouraged enhanced cooperation and harmonization of supervisory and regulatory arrangements across disciplines and national borders.

Directors commended the authorities for their assistance to developing countries, including through their support for the HIPC Initiative and for the European trade initiative to increase market access to low-income countries, and encouraged them to increase their overseas development assistance toward the UN target of 0.7 percent of GDP.

Directors praised the generally high quality, comprehensiveness, and timeliness of Finland's economic statistics.